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short essays and reports on the economic issues of the day
2004 ■ Number 15

Why Do Stock Prices React to the Fed?
Hui Guo
bservers of financial markets have noted that monelongest economic expansion since World War II. Business
tary policy actions sometimes have a large effect on
conditions were not so favorable in the late 1970s: The U.S.
the equity market; stock prices respond rapidly and
economy suffered from a severe recession and high inflation
positively (negatively) to unexpected monetary easing (tightafter the 1973 oil crisis and stock prices fell steeply as well.
ening), e.g., an unexpected decrease (increase) in the federal
Thus, these two periods provide an opportunity to investigate
funds rate target. This behavior is consistent with rational
the asymmetric effect of monetary policy on equity prices.
capital asset pricing models, in which a stock’s price is equal
The accompanying chart plots the average response of
to the discounted future cash flow of income to the owner of
stock prices to an unanticipated 1-percentage-point increase
the stock. That is, many financial economists argue that, if the
in the federal funds rate for stock portfolios formed on market
equity premium—the rate of return that investors demand on
capitalization, ranging from the smallest stocks (decile 1) to
stocks relative to the risk-free rate of interest—is approximately
the largest stocks (decile 10). As expected, all stock portfolios
constant, a monetary tightening raises the risk-free rate and
reacted negatively to a monetary tightening in both periods.
thus the discount rate, which in turn lowers stock prices.
Interestingly, the absolute value of the response decreases
Alternatively, a monetary tightening might lower stock
monotonically with firm size in the 1970s: It is 2.7 percent
prices by adversely affecting future cash flows. Bernanke and
for the smallest stocks, compared with 1.1 percent for the
Gertler (1989) show that this effect can be important if (i)
largest stocks, which is a statistically significant difference. In
firms have insufficient internally generated funds to finance
contrast, there is no obvious relation between the response to
new projects and (ii) external funds are more expensive than
a monetary tightening and firm size in the 1990s. Therefore,
internal funds.1 In particular, they argue that the premium
these results are consistent with a credit channel of monetary
transmission. ■
on external funds is negatively related to a firm’s collateral or
net worth. Therefore, a monetary tightening, by reducing net
Bernanke, Ben and Gertler, Mark. “Agency Costs, Net Worth, and Business
worth, increases the cost of external financing and forces liqFluctuations.” American Economic Review, March 1989, 79(1), pp. 14-31.
uidity-constrained firms to operate at lower scale.
Guo, Hui. “Stock Prices, Firm Size, and Changes in the Federal Funds Rate
A distinct implication of this credit channel of monetary
Target.” Quarterly Review of Economics and Finance (forthcoming).
transmission is that monetary policy has a greater
impact on small firms than on large firms because
small firms usually have less retained earnings
Reaction of Stock Prices to a 1-Percentage-Point Increase
and thus are more vulnerable to adverse liquidity
in the Federal Funds Rate Target 1974-79 and 1988-2000
shocks. Also, the effect should be more pronounced
during economic recessions, when liquidity is
scarce, than during economic expansions, when
liquidity is generally more abundant. Therefore,
we would expect stock prices of small firms to
respond more strongly to monetary innovations
than those of large firms during economic down–3
turns, although not necessarily during economic
Guo (forthcoming) analyzes the stock market
Size Decile
reaction to unanticipated changes in the federal
funds rate target in the periods 1974-79 and 1988SOURCE: Guo (forthcoming).
2000.2 In the 1990s, the United States enjoyed the


Views expressed do not necessarily reflect official positions of the Federal Reserve System.